The Growing Impact of "Mini Muni" Bonds

Hundreds of small, unrated municipal bonds are hitting rocky times and missing payments. Will bond investors see their portfolios suffer?

By

RussellPearlman

Of all the places to park cash after the financial crisis, the Oppenheimer Rochester Municipals fund seemed like an obvious choice. The fund, as its name implies, is filled with municipal bonds, those boring pieces of debt that typically finance sewers, highways and other civic projects. Those bonds have offered attractive yields and, for New York residents in particular, a ton of protection from taxes. So it's not surprising that the fund's assets grew more than 30 percent in the year after the crash.

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But it turns out, the $7.7 billion fund, one of the largest muni bond funds in the U.S., has been buying things that might surprise investors. The fund owns bonds that finance run-of-the-mill drainage projects and roads, but it also has a stake in a financially strapped nursing home, a hospital that has missed two bond payments and a charter school that shut its doors. The fund even owns the bonds of the American Folk Art Museum, known for its collection of unique quilts and, now, for not making payments on its $32 million in debt. (Its revenue fell almost 75 percent in two years, according to public documents.) Smaller, less traditional bonds like these seldom have independent ratings of their creditworthiness, but they make up almost one-fifth of the Oppenheimer fund's holdings. And the fund has underperformed the industry's main benchmark by nearly four percentage points during the past 12 months. Dan Loughran, the fund's manager, attributes those numbers to market conditions and downplays the impact of these little bonds; indeed, less than one-tenth of 1 percent of the bonds the fund holds are considered to be in default. But he agrees this type of debt could cause more trouble for investors. "There is no government that is legally or morally on the hook to use taxpayer money to bail them out," he says.

Over the past year, what has historically been one of the safest investments in America hasn't felt quite so safe. Last June SmartMoney pointed out that there were cracks in the $3 trillion municipal bond market. Since then, there's been a flood of headlines about budget woes in California, Illinois and other states, and their struggles to pay their billions in debt. On a 60 Minutes segment in December, one expert even predicted that muni defaults could reach levels unseen since the Depression. But while investors have been fretting over the high-profile, multibillion-dollar state bonds, the next chapter in the muni mess has been unfolding outside the spotlight, involving a class of much smaller bonds that get little—if any—taxpayer support.

Call them the mini munis. Few people outside the industry even know these bonds exist, but over the past decade billions of dollars' worth were issued by governments—in many cases to help private developers build golf courses, hotels or million-dollar condominiums. In each case, the bonds were floated based on promising projections of a revenue stream, even though most smaller-denomination bonds don't get rated by outside agencies that can judge whether that stream will become more than a trickle. Today, in a startling number of instances, the revenue hasn't materialized, and now it's these bonds that experts say are facing the most immediate troubles. "There's a lot of stress in the smaller issues, the ones that are on the fringe," says Reid Smith, a veteran municipal bond investor for RBC Global Asset Management.

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To be fair, the sky isn't exactly falling in the muni bond world. Actual defaults among muni bonds, big or small, remain extremely rare, and many advisers continue to treat them as safe havens. Still, mini munis make up a high proportion of the flare-ups that do occur; in the past two years alone, 231 unrated bonds, representing more than $5 billion in investor-held debt, have defaulted, according to Massachusetts-based Municipal Market Advisors. That's four times the market value of the handful of rated bonds that got in trouble over the same period. And mini munis make up two-thirds of the roughly $22 billion in muni debt that's in serious trouble, says Richard Lehmann, author of the Distressed Debt Securities newsletter and a longtime bond market analyst. Nonetheless, the pitches keep coming, according to financial planners like Dennis Stearns of Greensboro, N.C., who has several mini muni–funded assisted-living facilities in his area. "People look at that as a slam dunk to make a good yield," Stearns says. "There is a lot more risk than they think."

To a casual observer, it might seem as though the worst of the muni bond tempest has already blown over. True, the ugly fiscal condition of state and local governments became Topic A for many investors a few months back, especially after banking analyst Meredith Whitney—best known for predicting the 2008 financial crisis—warned that she expected hundreds of billions of dollars' worth of defaults. Since then, investors have pulled about $40 billion out of municipal bond funds. But the rate at which they've been fleeing has recently slowed, and confidence in munis has perked up a bit. That's in part because many big munis have a big advantage: The governments behind them can raise taxes and fees to cover the payments. Indeed, some already have, notably the state of Illinois, which helped shore up investors' faith in its bonds when it recently hiked its income tax rates.

But mini munis that fund things like golf courses and museums aren't usually designed to be backed by taxes. Many investors might be a tad bewildered to find that those projects involve munis at all—since muni bonds, which have been part of the U.S. economic scene since the early 1800s, are supposed to pay for projects that have "an essential public purpose," according to the Municipal Securities Rulemaking Board. Most muni money does go into traditional projects: Last year states, cities and towns issued $25 billion to finance road construction alone. But over the past decade, private developers have figured out how to jump on the bondwagon. There are now more than 40,000 quasi-governmental agencies across the country that have the authority to issue muni bonds, according to industry experts, and they've used their power to finance more than just local schools. Need a football stadium built? How about a Hyatt resort? Or a housing subdivision on vacant farmland? For all these things, builders turned to the muni market. It's one of the reasons the total amount of muni debt has doubled during the past 10 years. "People went bananas financing everything and anything with municipals, regardless of purpose," says Robert Lamb, a municipal bond expert and finance professor at New York University's Stern School of Business.

For a few years, this arrangement worked out well for everyone concerned. Developers got their projects financed, governments got new buildings without having to raise taxes, and investors—especially retirees looking for a steady income—reaped as much as 6 percent interest, much of it tax-free. But that was before the housing bust, the recession and the financial crisis came along in quick succession. Money dried up fast, and bonds began to look shakier. One issue aggravating the problem: An alarming lack of disclosure. Bondholders are supposed to get regular updates about their investments, but some mini-muni issuers go years without reporting on the soundness of their finances, says Kathleen Hawk of DPC Data, a consultant for bondholders. According to a study DPC released this year, 40 percent of muni bond issuers didn't file required disclosures in 2009, and a fifth of issuers have been delinquent in filing for five years running.

Whether they're disclosing it or not, there's plenty of evidence that issuers are in trouble. Lehmann, the distressed-debt expert, says $5 billion worth of munis issued in Florida alone have defaulted over the past five years, because the housing developments they financed were never finished. In one project in California, developers took on $9.5 million in muni debt to finance two pristine golf courses and hundreds of vacation homes in Borrego Springs, a town 90 miles northeast of San Diego—smack dab in the middle of the desert. The developer needed to sell 600 housing lots to break even; it sold 300. Not enough people wanted second homes, it seems, in a town whose website boasts that the nearest stoplight is 50 miles away. The borrowers went into default, and in February they failed to make part of a payment. When the economy went south, "selling houses in a remote area became very difficult," says Greg Perlman, principal of GH Capital, the project's developer, who adds that bondholders will likely get paid—eventually.

A lot of these projects were built on assumptions that have turned out to be, at a minimum, very optimistic. The backers behind the $600 million Las Vegas monorail project expected 50,000 riders a day; they've averaged only 20,000, and bondholders haven't been paid since early 2010. (The monorail developer is still in discussions with creditors, a spokesperson says.) Or take the parking lot—actually 12 parking lots and garages—surrounding the new Yankee Stadium in New York City, financed with $238 million in muni debt and completed in 2009. Bronx Parking Development, the bond agency that owns the lots, expected more than 85 percent of the 8,000-plus parking spaces to be filled on game days, for about $25 a car. But it appears that more people like the romance of getting to the Bronx on the subway; last year only about half of the spaces were filled. The parking spaces probably won't produce enough cash to cover the $13 million owed on the project's next two debt payments, says Steven Polivy, a lawyer representing the development agency.

For some investors, it's tempting to dismiss this morass as a financial afterthought. After all, there aren't many people who own debt of the American Folk Art Museum outright. A large number of investors, however, still have a piece of these tiny bonds—through bond funds. Indeed, some of the biggest funds are chock-full of these small fry. Nearly half of the 1,200-plus bonds held by the $4.3 billion Nuveen High Yield Municipal Bond fund are unrated—among them, debt from the Borrego golf project and the Yankee Stadium parking lots. Over the past year, the fund is down 1.2 percent, trailing other high-yield muni funds and the average for muni funds.

John Miller, the Nuveen fund's manager, says many of those smaller bonds offer potentially good returns. "Nonrated is not necessarily bad," Miller says. Analysts say that because the mini munis' dollar values are small, owning a few such clunkers may not even hurt a fund's performance, much less put it in grave danger. Fund managers who own the bonds say they inform their investors about any risks they entail. Still, the numbers suggests that loading up on mini munis hasn't been paying off of late. The 10 funds with the highest percentage of unrated mini munis averaged a 0.4 percent return over the past year, and all of them trail the industry's main benchmark, the Barclays' Capital Municipal index, which returned 1.6 percent over that stretch.

When mini munis show up in an individual's holdings, they can create a genuine hassle. Dan Genter, president of RNC Genter Capital Management, a 60-employee investment management firm in Los Angeles, says his firm frequently gets stuck with these mini munis, particularly bonds for health care and housing developments, when it brings on new clients. He says some of his new clients were "suffering from terminal greed" and urged their former brokers to chase as much interest as they could get. Genter says his firm, which manages $3.7 billion, routinely marks these bonds as "impaired" and tries to sell them, but there is no longer a market for many of them. Clients may be lucky to get 50 cents on the dollar.

That's the kind of price a pro hates to contemplate, but it's still not as ugly as the D-word: default. A worst-case scenario—spoken of only in hushed tones by some industry watchers—would be a huge wave of defaults in mini munis that undermined confidence in the entire market, causing a mass sell-off and an exodus from what used to be an investor's oasis. It's an unlikely outcome, but at the very least, some investors are starting to insist on a closer look at any municipal bonds they own, big or small. Just a few years ago, clients of Houston-based financial-advisory firm Kanaly Trust knew nothing about the muni bonds they owned, other than when they matured and how much interest they paid. Now, says James Shelton, Kanaly's chief investment officer, many clients are asking the same question: "Do I own any of this crap?"

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